EU regulation is making the next crash inevitable

The European Parliament is back in full session, carrying on as if nothing untoward were taking place beyond its walls. José Manuel Durão Barrosois calling for federalism and a new world order. MEPs are regulating private industries whose workings they barely understand.

Their chief target in this session is the financial services sector, which they find at once baffling and frightening. You won’t be surprised to learn that their proposals will drive business out of the EU as a whole, and London in particular. What might surprise you is that, at the same time, they make another banking collapse far more likely.

Bank failures are not a sign that capitalism has broken down. On the contrary, they are a sign that capitalism is working. A market depends on the removal of inefficient businesses to make room for new competitors: that’s the process that drives economic growth and raises living standards. It’s why we enjoy material comforts that our great-grandfathers couldn’t have imagined.

The EU’s approach to financial services is based around preventing failure. Every proposal – from the requirements to hold a specified amount of capital to the forms of external supervision – is designed to create a system where banks won’t collapse.

In fact, our goal should be to have a situation where banks can collapse without disastrous effects: a pluralist market in which thousands of suppliers compete against each other, and in which the failure of one is an opportunity for more efficient rivals to take over its operations and offer a superior service.

Around a million people work in financial services in the UK, half of them for firms with fewer than 200 employees. These smaller companies are run by their owners, and don’t need to be told to remain solvent: bankruptcy means losing everything. Yet they are forced to spend more and more time complying with UK and EU rules designed, not to address a specific problem, but to give the impression that something is being done. The FSA guide to regulation now runs to 10,500 pages. No bank or private equity firm can get away with spending less than five per cent of its budget on compliance – money which would otherwise be spent on creating jobs and maximising returns. Vast documents are emailed to potential investors, who never read them, but take away the false impression that someone somewhere is on top of the risk.

Many smaller operators, unable to afford the compliance costs, are being taken over by the behemoths. Brussels shouldn’t bear the blame alone: Gordon Brown also did his bit to encourage bank consolidation. But Brussels is, if anything, even more susceptible than national governments to lobbying by giant banks. These monsters crave regulation, knowing that it puts their smaller rivals out of business. Across Europe, they are careful to ensure that policymakers have a stake in their success.

The boards of large French banks are filled with former civil servants. Four giant banks now control 85 per cent of the French market. Across large parts of the continent, and now in Britain too, big banks are run as quasi-nationalised industries. Like all nationalised industries, they operate on the assumption that taxpayers will support them if things go wrong.

These megabanks caused the crash, and are even now forcing the EU and the IMF to assume their bad debts. Eurocrats turn the other cheek to the organisations that have lumbered taxpayers with these colossal liabilities, while demanding the uttermost farthing from the small investment funds that were wholly innocent of causing the 2008 breakdown.

You can blame an awful lot of people for the credit crunch: banks, regulators, governments, credit rating agencies. One lot of people you can’t blame are hedge funds and other equity firms. On the contrary, they were among the chief victims. Some went under, others took their losses stoically. None asked for a bailout. Yet several EU regulations, notably the Alternative Investment Fund Managers Directive, have been targeted at them.

Why? Partly because more than 70 per cent of managed capital in the EU is run from London, and Britain has few friends in Brussels. Partly, too, out of a slightly mediaeval attitude to capitalism. Most MEPs and Commission functionaries struggle with the concept that services are just as real as manufactured goods. As they see it, fund managers are scavengers who profit from the ‘genuine’ work of those who bash metal for a living. (Irony has never been the MEP’s strong suit, which is why he is able, unblushingly, to complain about someone else not doing a ‘proper’ job.)

When a brawl breaks out in a pub, you don’t hit the chap who started it, you hit the one you’ve always longed to thump. This is especially true if the chap who started it is a vast, hulking fellow. Thus, British financial services find themselves picked on because of an unrelated problem in the leviathan banks.

It’s not just that the EU is hitting the wrong target, it’s that Brussels rules are actively exacerbating the problem by encouraging takeovers and raising barriers to new entrants.

Like every elected representative, I have on my desk a tottering pile of letters from small businessmen who can’t get loans. Next to them is an equally large pile from elderly constituents whose savings have suddenly ceased to yield any return. Why is no one putting the former in touch with the latter? Where are the new banks?

The answer is that they are remarkably difficult to launch. The paperwork takes at least two years. While there are some new entrants, the market remains dominated by massive conglomerates – just as Japan was before its own banking crash in the 1990s.

What should do instead? We should drop the whole notion of external invigilation of financial services: the FSA has surely proved its worthlessness, and the three new EU regulatory bodies will exacerbate those flaws.

Rather, we should make bank directors personally liable for their losses, as Steve Baker, the superb MP for Wycombe, recently proposed in a Bill. The reason that large banks have more serious problems than small ones is that their Boards behave as employees rather than owners, their shareholders as investors rather than proprietors.

Think of it another way. The three big City professions are law, accountancy and financial services. The first two still largely operate on a partnership model: their directors own the company. Which sector caused the crash?

When Brazil had its own bank crash, it passed a short Bill making directors personally liable. It has had remarkably little trouble since.

Instead of pretending that an outside agency can police the system, we need to shift the personal incentives. You shouldn’t need to tell a bank not to fail: failure is bad business. Nor should you need to tell it lend: that’s how it makes a profit. All you need to do is ensure that the people running it will suffer if things go wrong.

Sadly, the EU is going in precisely the opposite direction, passing regulations which are at once expensive and ineffective, killing off small operators, encouraging mergers and raising barriers to entry. In other words, Brussels has itself created the phenomenon of ‘too big too fail’ which is at the root of the problem.